Financial Options

Ramabhadran S. Thirumalai
Indian School of Business

CFIN2, Term 4, Class of 2020

Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Agenda
1 Introduction
2 Option Basics
Payoffs
Moneyness
3 Options Combinations
4 Option Pricing Relationships
European Put-Call Parity
Factors Affecting Option Premiums
The Black-Scholes-Merton Model
5 Wrap-up

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 2 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Economic assets

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 3 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Options types and styles

• Gives the holder the right to trade the underlying asset at a stated
price (called the exercise or strike price)
I Right to buy: call
I Right to sell: put
• Can be viewed as insurance contracts
• Two styles of options:
I European - can be exercised only on expiration date
I American - more flexible; can be exercised any time prior to or on
expiration date
I Note: the names are not a reflection of where they trade

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 4 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Option positions and payoffs

• Two sides to any option position:
I Long/holder: buys the right to exercise the option and pays the premium
I Short or writer: sells the right to exercise the option and receives the
premium

• Payoffs at expiration:
I Long call: max (S − K , 0)
I Short call: − max (S − K , 0) = min (K − S, 0)

I Long put: max (K − S, 0)

I Short put: − max (K − S, 0) = min (S − K , 0)

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 5 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Option payoff diagrams

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 6 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Moneyness of options
• At-the-money option: An option whose payoff is zero if exercised
immediately
I S=K
• In-the-money option: An option that has a positive payoff if
exercised immediately
I Calls: S > K
I Puts: S < K
• Out-of-the-money option: An option that has a negative payoff if
exercised immediately
I Calls: S < K
I Puts: S > K

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 7 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Straddles
• At times, investors hold different types of options with various
strike prices based on their expectation of stock price movements
• Straddle combination:

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 8 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Strangles

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 9 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Butterfly spreads

• Involves options, either all calls or all puts, with three different
strike prices
I Buy a call with a relatively low strike price K1 and one with a relatively
high strike price K3 and sell 2 calls with a strike price K2 , where K2 is the
midpoint of K1 and K3

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 10 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Butterfly spreads

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 11 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Butterfly spreads

• What are your expectations about asset price if you enter into a
butterfly spread?
• Similar spread with puts

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 12 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Protective puts
• Used in the mutual fund industry
• Fund manager wants to protect the value of her fund when a
downturn is expected
• She already owns the stocks
• How does she create this downside protection?
• When prices decrease, the value of the fund or portfolio should not
decrease
• However, when prices increase, the upside profit should not be
limited

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 13 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Protective puts

• What happens if she buys a put?

• Prices decrease, value of fund decreases but payoff from put
increases
• Payoff of portfolio plus put is S + max (K − S, 0) = max (K , S)

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 14 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

European Put-call parity

• What does the payoff of a protective put look like?

• A call plus some fixed amount of cash K
• Let’s form a portfolio by buying call option with strike price K and
investing PV (K ) at the risk-free rate of return
• At expiration of the call, the payoff of this portfolio is
max (S − K , 0) + K = max (S, K )
• Where did we see this?
• Same payoff as a protective put

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 15 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

European Put-call parity

• This means that a protective put should cost the same as buying a
call option and investing PV (K ) today
• S + P = C + PV (K ) ⇐ the very important put-call parity;
applicable only to European options

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 16 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Factors that affect option premiums

Effect of an increase in the factor on option value (ceteris paribus)

Factor C P
Stock price ↑ ↓
Strike price ↓ ↑
Time to expiration ↑ ↑
Volatility of returns ↑ ↑

Ram Thirumalai Financial Options

CFIN2, Term 4, Class of 2020 17 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

The Black-Scholes-Merton model

C = SN (d1 ) − PV (K )N (d2 )
P = PV (K )N (−d2 ) − SN (−d1 )
where
√
ln [S/PV (K )] σ T
d1 = √ +
σ √T 2
d2 = d1 − σ T
K
PV (K ) =
(1 + r )T
N (x ) is the area under a standard Normal distribution to the left of
x
Ram Thirumalai Financial Options
CFIN2, Term 4, Class of 2020 18 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Example
• European call with T =2 months and K =500, S=500, σ=0.30,
r =0.05 √
ln [S/PV (K )] σ T
• d1 = √ + =
 σ T  2
500
ln   q
500/(1 + 0.05)2/12 0.30 × 2/12
q + = 0.1276
0.30 × 2/12 2
√ r
2
• d2 = d1 − σ T = 0.1276 − 0.30 × 12 = 0.0051
• N (d1 ) = N (0.13) = 0.5517
• N (d2 ) = N (0.01) = 0.5040
• C = SN (d1 ) − PV (K )N (d2 ) =
500
500 × 0.5517 − × 0.5040 = 25.89
(1 + 0.05)2/12
Ram Thirumalai Financial Options
CFIN2, Term 4, Class of 2020 19 / 20
Introduction Option Basics Options Combinations Option Pricing Relationships Wrap-up

Key takeaways
• Define the two common types and two common styles of options
• Calculate the payoff of European options and draw the payoff diagram on their
expiration date
• Define what in-the-money, at-the-money and out-of-the-money options are
• How do you create straddles, strangles and butterfly spreads and what are the
expectations of underlying asset’s price for each of these combinations?
• What is a protective put?
• What does European put-call parity say and how can it be used?
• Explain how the four factors affect option premium
• Calculate European call and put premium using the Black-Scholes-Merton model
Ram Thirumalai Financial Options
CFIN2, Term 4, Class of 2020 20 / 20